Electronic copy available at: http://ssrn.com/abstract=2185420

Brooklyn Law School Legal Studies

Research Papers

Accepted Paper Series

Research Paper No. 317 December 2012

Once a Failed Remic, Never a Remic

Bradley T. BordenDavid J. Reiss

This paper can be downloaded without charge from theSocial Science Research Network Electronic Paper Collection:

http://ssrn.com/abstract=2185420

Electronic copy available at: http://ssrn.com/abstract=2185420

1 8/31/2012

ONCE A FAILED REMIC, NEVER A REMIC

Bradley T. Borden & David J. Reiss*

Forthcoming in the CAYMAN FINANCIAL REVIEW (http://www.compasscayman.com/cfr/)

Investors in mortgage-backed securities, built on the shoulders of the tax-advantaged

Real Estate Mortgage Investment Conduit (“REMIC”), may be facing extraordinary tax losses

because of how bankers and lawyers structured (or failed to structure) these securities. This

calamity is compounded by the fact that those professional advisors should have known that the

REMICs they created were flawed from the start.

A History of REMIC-able Growth

Before 1986, complex mortgage-backed securities had various tax-related inefficiencies.

First amongst them, these securities were taxable at the entity level and so investors faced double

taxation. Wall Street firms successfully lobbied Congress to do away with double taxation in

1986. This legislation created the REMIC, which was not taxed at the entity level. This one

change automatically boosted its yields over other mortgage-backed securities that would

otherwise be taxed. Unsurprisingly, REMICs displaced other types of mortgage-backed

securities and soon became the dominant choice of entity for such transactions.

The process for creating a REMIC can be fairly complex, but a simple diagram of the

original process provides sufficient framework for discussion and analysis. Loan originators lend

* Brad and David are professors at Brooklyn Law School. © 2012 Bradley T. Borden and David J. Reiss. This brief

article is drawn from a forthcoming study by the authors and builds on an earlier discussion of these issues in

Bradley T. Borden & David J. Reiss, Wall Street Rules Applied to REMIC Classification, THOMSON REUTERS NEWS

& INSIGHT (Sep. 13, 2012), available at http://newsandinsight.thomsonreuters.com/Securities/Insight/2012/09_-

_September/Wall_Street_Rules_Applied_to_REMIC_Classification/.

Electronic copy available at: http://ssrn.com/abstract=2185420

2 8/31/2012

money to borrowers who use the proceeds to purchase a residence.1 The borrowers execute a

mortgage notes in favor of the originator for the amount of the loan and grant the originator a

mortgage on the residence. The originator records the mortgages in the county clerk’s office. The

originator sells the mortgage notes and assigns the mortgage to a REMIC sponsor. The sponsor

records assignments of mortgages in the county clerk’s office. The sponsor transfers the

mortgages notes and assigns the mortgage to a REMIC trust in exchange for beneficial interests

in the trust. The REMIC trustee records the assignment of the mortgage, and the sponsor sells the

beneficial interests to investors. The following diagram depicts the traditional securitization

process.

1 A REMIC may include mortgages secured by real estate other than a home, but this article focuses on residential

mortgage-backed REMICs.

3 8/31/2012

A REMIC allows for the pooling of mortgage loans that can then be issued as a multiple-

tranche mortgage-backed security.2 A REMIC is intended to be a passive investment in a static

pool of mortgages. Because of its passive nature, a REMIC is limited as to how and when it can

acquire mortgages.3 In particular, a REMIC must in most cases acquire its mortgages within

three months after its start-up.4 The Internal Revenue Code provides for draconian penalties for

REMICs that fail to comply with applicable legal requirements.

In the 1990s, the housing finance industry, still faced with the patchwork of state and

local laws relating to real estate, sought to streamline the process of assigning mortgages from

the loan originator to a mortgage pool. Industry players, including Fannie and Freddie and the

Mortgage Bankers Association, advocated for The Mortgage Electronic Recording System

(“MERS”), which was up and running by the end of the decade. A MERS mortgage contains a

statement that “MERS is a separate corporation that is acting solely as nominee for the Lender

and Lender’s successors and assigns. MERS claims to be the mortgagee under this Security

Instrument.”5 MERS is not, however, named on any note endorsement. This new system saved

lenders small but not insignificant amounts of money in recording fees and administrative costs

every time a mortgage was transferred. But the legal status of this private recording system was

not clear and had not been ratified by Congress. Notwithstanding that fact, nearly all of the

major mortgage originators participated in MERS and it registered millions of mortgages within

2 See JOINT COMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE TAX REFORM ACT OF 1986, 411 (H.R. 3838,

99th Cong; P.L. 99-514) (hereinafter “THE 1986 BLUEBOOK”) (“[T]he Congress believed that the provisions of the

Act should apply to any multiple class entity used for packaging interests in mortgages, regardless of the legal form

used, provided that the interests satisfy the specified substantive requirements.” (emphasis added)). 3 See THE 1986 BLUEBOOK at 411 (“The Congress believed that there should be some relief from two levels of

taxation (i.e., at the entity level and at the shareholder level) where an entity with multiple classes of interests holds

only a pool of real estate mortgages and related assets, has no powers to vary the composition of its mortgage assets,

and has other powers generally consistent with the preservation of trust status, provided that satisfactory rules are

prescribed for the taxation of the multiple interests.” (emphasis added)), 412 (“In general, a REMIC is a fixed pool

of mortgages with multiple classes of interests held by investors.” (emphasis added)). 4 26 U.S.C. § 860G(a)(3), (9).

5 See, e.g., BROOK BOYD, REAL ESTATE FINANCING § 14.05[9] (2005).

4 8/31/2012

a couple of years. By 2009 MERS claimed to be the nominal mortgagee on approximately two-

thirds of all newly-originated residential loans.6

Beginning in early 2000s, MERS and other parties in the mortgage securitization industry

began to relax many of the procedures and practices they originally used to assign mortgages

among industry players. Litigation documents and decided cases reveal how relaxed the

procedures and practices became. Hitting a crescendo right before the global financial crisis hit,

the loan origination and securitization practices became egregiously negligent, perhaps criminal.

The practices at Countrywide Home Loans, Inc. (then one of the nation’s largest loan

originators in terms of volume and now part of Bank of America) illustrate the outrageous

behavior of mortgage securitizers during that period of time. The court in In re Kemp documents

in painful detail how Countrywide failed to transfer possession of the note to the pool backing

the securities so that Countrywide failed to comply with the requirements necessary to obtain

REMIC status for that mortgage.7 Numerous other filings and reports suggest that

Countrywide’s practice was typical of many major lenders during the early 2000s.8 In fact, in

addition to failing to transfer mortgage notes, the parties often failed to assign and record the

mortgages. Prior to the 2008 Financial Crisis, the REMIC securitization process had devolved

into something depicted by the following diagram—notice that the originator does not transfer

the mortgage note, and recording of the mortgage assignment often occurred long after the

purported transfer, if at all.

6 See Jackson v. Mortgage Electronic Registration Systems, Inc., 770 N.W. 2d 487, 490–92 (Minn. 2009).

7 See In re Kemp, 440 F.R. 624 (Bankr. D.N.J. 2010). See also Cutler v. U.S. Bank National Association, No. 2D10-

5709 (Fla. App. 2d Dist. Sep. 21, 2012) (holding that if a bank was the holder of a note at the time it brought a

foreclosure action, it did not have standing to bring the action). 8 See Developments in Real Estate Finance, available at http://refinblog.com/ (tracking changes in the law and

practices of the real estate finance industry).

5 8/31/2012

A suit filed by the New York Attorney General (the Schneiderman Complaint) also

details in its allegations how loan originators and REMIC sponsors colluded to populate

REMICs with faulty mortgages.9 A suit filed on behalf of Freddie Mac and Fannie Mae (the

Fannie Complaint) also alleges the corrupt practices of loan originators that have implications for

REMICs’ tax-advantaged status.10

The practices of loan originators and REMIC sponsors have

causes severe losses and have undermined the U.S. property system. Significant litigation has

grown out of those losses and damage to the property system. Investors who purchased

beneficial interests in REMIC trusts are suing the parties who put the REMICs together and

promoted them.11

State and federal prosecutors are also bringing actions for fraud and

9 See Complaint, New York v. J.P. Morgan Securities LLC, NO. 451556/2012 (County of New York, Oct. 10,

2012). 10

See Complaint, Federal Housing Finance Agency v. JPMorgan Chase & Co., No. 11 Civ. 6188 (DLC) (S.D.N.Y.

June 13, 2012). 11

See, e.g., Consolidated Complaint at 20–22, HSH Nordbank AG v. Barclays Bank PLC, No. 652678/2011

(County of New York Apr. 2, 2012) (claiming REMIC promoters misrepresented information about the pooled

mortgages and committed fraud); The Western and Southern Life Insurance Company v. Residential Funding

Company, No. A1105042 (Hamilton County Ohio June 6, 2012) (denying motions to dismiss claims against

6 8/31/2012

misrepresentation against the sponsors.12

This body of litigation is depicted as upstream litigation

in the diagram below. MERS, banks, and REMIC trustees are involved in litigation with

homeowners and borrowers regarding the legal rights that the banks and trustees have to enforce

mortgage notes and foreclose on property.13

Counties have also brought lawsuits against MERS

and banks seeking recording fees for purported transfers of the mortgage notes.14

The diagram

depicts this body of legal action as downstream litigation.

organizers of residential mortgage-backed securities (RMBS)); Pennsylvania Public School Employees’ Retirement

System v. Bank of America Corporation, No. 11 Civ. 733 (S.D.N.Y. 2012) (denying Bank of America’s motion to

dismiss the Section 10(b) and Rule 10b-5 claim against it because the plaintiff’s allegations concerning Bank of

America’s “misstatements and omissions concerning its reliance on MERS, vulnerability to repurchase claims,

internal controls, and compliance with GAAP and SEC regulations” satisfied the requisite standard to raise a strong

inference of the bank’s misconduct and scienter regarding the misconduct). 12

See, e.g., Complaint, New York v. J.P. Morgan Securities, supra note 9; Complaint, New York v. Credit Suisse

Securities, No. 451802/2012 (County of New York, Nov. 20, 2012); Amended Complaint at 32–33, Federal Housing

Finance Agency v. JPMorgan Chase & Co. et al, No. 11 CV. 6188 (DLC) (S.D.N.Y. June 13, 2012) (describing

origination practices of some notes); Complaint-in-Intervention of the United States of America, United States v.

Bank of America, 12 Civ. 1422 (JSR) (S.D.N.Y. Oct. 24, 2012) (claiming that Countrywide, as originator,

eliminated checkpoints, resulting in fraud and loan defects while Countrywide represented it had tightened its

underwriting standards). 13

See, e.g., Fowler v. Recontrust Companay, N.A., 2011 WL 939863 (D. Utah Mar. 10, 2011) (holding that MERS

is the beneficial owner under Utah law); Jackson v. Mortgages Electronic Registration Systems, Inc., 770 N.W. 2d

487 (Minn. 2009) (holding that MERS, as nominee, could institute a foreclosure by advertisement, i.e., a nonjudicial

foreclosure, based upon Minnesota “MERS statute” that allows nominee foreclosure); Gomes v. Countrywide Home

Loans, Inc., 192 Cal.App.4th 1149 (Cal. App. 2011) (finding that MERS had authority to foreclose on behalf of the

note holder because of the authority granted to it under the deed of trust); Bain v. Metropolitan Mortgage Group,

Inc., 285 P.3d 34 (Wash. 2012) (holding that MERS was not a beneficiary under Washington Deed of Trust Act

because it did not hold the mortgage note); Eaton v. Federal National Mortgage Association, 462 Mass. 569 (Mass.

2012) (holding that mortgagee must hold the note to foreclose or act with the authority of the note holder); Ralph v.

Met Life Home Loans, No. CV 2010-0200 (5th D. Idaho Aug. 10, 2011) (holding that MERS was not the beneficial

owner of a deed of trust, so its assignment was a nullity and the assignee could not bring a nonjudicial foreclosure

against the borrower); Landmark National Bank v. Kesler, 289 Kan. 528, 216 P.3d 158 (Kan. 2009) (holding that

MERS had no interest in the property and was not entitled to notice of bankruptcy or to intervene to challenge it).

Litigation in this area is moving quickly, so even work done a few years ago is not up to date. Nonetheless, an early

article with a nice overview of cases that consider state-law issues associated with MERS recording is John R.

Hooge & Laurie Williams, Mortgage Electronic Registration Systems, Inc.: A Survey of Cases Discussing MERS’

Authority to Act, NORTON BANKRUPTCY LAW ADVISOR 1 (Aug. 2010).. 14

See, e.g., Margaret Cronin Fisk & Tom Korosec, Bank of America, MERS Lose Bid to Dismiss Texas Fee Suit,

BLOOMBERG BUSINESSWEEK (May 24, 2012), available at http://www.businessweek.com/news/2012-05-23/bank-

of-america-mers-lose-bid-to-dismiss-texas-fee-suit.

7 8/31/2012

To date, hundreds of such suits have been filed, and there appears to be no immediate end

in the number that will be filed.15

Courts are still struggling to determine the legal fallout of the

mess that banks and MERS have created.

Sloppiness and REMICs Rules Don’t Mix Well

Even though some securitizers may have followed the terms contained in the applicable

Pooling and Servicing Agreements that governed REMIC mortgaged-backed securities, the very

low tolerance for deviation in the REMIC rules suggests that partial compliance could result in a

15

See Developments in Real Estate Finance, available at http://refinblog.com/ (tracking changes in the law and

practices of the real estate finance industry).

8 8/31/2012

finding that individual REMICs fail to comply with the strict requirements of the Internal

Revenue Code. This would cause those REMICs to lose their preferred tax status.16

To obtain REMIC classification, a trust must satisfy several requirements. Of particular

interest is the requirement that within three months after the trust’s startup date substantially all

of its assets must be qualified mortgages.17

The regulations provide that substantially all of the

assets of a trust are qualified mortgages if no more than a de minimis amount of the trust’s assets

are not qualified mortgages.18

The regulations do not define what constitutes a de minimis

amount of assets, but they provide that substantially all of the assets are permitted assets if no

more than one percent (1%) of the aggregate basis of all of the trust’s assets is attributed to

prohibited assets.19

If the aggregate basis of the prohibited assets exceeds the 1% threshold, the

trust may nonetheless be able to demonstrate that it owns no more than a de minimis amount of

prohibited assets.20

Nonetheless, an amount significantly greater than 1% would appear to exceed

the de minimis exception. Thus, almost all of a REMIC’s assets must be qualified mortgages.

A “qualified mortgage” is an obligation that is principally secured by an interest in real

property.21

The trust must also acquire the obligation by contribution on the startup date or by

purchase within three months after the startup date.22

Thus, to be a qualified mortgage, an asset

must satisfy both a definitional requirement (be an obligation principally secured by an interest

in real property) and a timing requirement (be acquired within three months after the startup

date).

16

Surprisingly, however, the IRS appears to be unresponsive to this issue so far, and its failure probably contributed

to the financial crisis to some extent. See Bradley T. Borden, Did the IRS Cause the Financial Crisis?, HUFFINGTON

POST (Oct. 18, 2012), available at http://www.huffingtonpost.com/bradley-t-borden/did-the-irs-cause-the-

fin_b_1972207.html. 17

See IRC § 860D(a)(4). 18

See Treas. Reg. § 1.860D-1(b)(3)(i). 19

See Treas. Reg. § 1.860D-1(b)(3)(ii). 20

See id. 21

See IRC § 860G(a)(3)(A). 22

See IRC § 860G(a)(3)(A)(i), (ii).

9 8/31/2012

Industry practices raise questions about whether trusts satisfied either the definitional

requirement or the timing requirement. The general practice was for trusts and loan originators to

enter into Pooling and Servicing Agreements, which required the originator to transfer the

mortgage note and mortgage to the trust. Nonetheless, as in Kemp, reports and court documents

indicate that originators and trusts frequently did not comply with the terms of the Pooling and

Servicing Agreements and the originator typically retained possession of the mortgage notes and

MERS became the nominee of record on the mortgage.

The failure to property transfer the mortgage note and mortgage may cause the trusts to

fail both the definitional requirement and the timing requirement that are necessary to qualify for

REMIC status. They fail the definition requirement because they do not legally own obligations,

and what they do legally own does not appear to be secured by interests in real property. They

fail the timing requirement because they do not acquire the requisite interests within the three-

month prescribed time frame.

Even if the trusts acquired some obligations principally secured by interests in real

property, many of their assets would not satisfy the REMIC requirements. The Schneiderman

Complaint and Fannie Complaint allege that the loan origination practices and underwriting

standards become were severely flawed. If these allegations proved to be true, many of the

mortgages in REMIC pools will fail to be principally secured by interests in real property. This

would result in the trusts owning more than a de minimis amount of prohibited assets. If more

than a de minimis amount of a trust’s assets are prohibited assets, then it would not be eligible for

REMIC status.

The Un-MERS-iful Stringency of the REMIC Regulations

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Federal tax law does not rely upon the state-law definition of ownership, but it looks to

state law to determine parties’ rights, obligations, and interests in property.23

Tax law can also

disregard the transfer (or lack of transfer) of formal title where the transferor retains many of the

benefits and burdens of ownership.24

Courts focus on whether the benefits and burdens of

ownership pass from one party to another when considering who is the owner of property for tax

purposes.25

The analysis of ownership does not merely look to the agreements the parties

entered into because the label parties give to a transaction does not determine its character.26

The analysis must examine the underlying economics and the attendant facts and circumstances

to determine who owns the mortgage notes for tax purposes.27

Courts in many states have considered the legal rights and obligations of REMICs with

respect to mortgage notes and mortgages they claim to own. Courts are split with some ruling in

favor of MERS and others ruling in favor of other parties whose interests are adverse to MERS.

Apparently, no court has considered how significant these rules are with respect to REMIC

classification. Standing to foreclose and participate in a bankruptcy proceeding will likely affect

the tax analysis of whether REMIC trust assets are secured by an interest in real property, but

they probably do not affect the tax analysis of whether the REMIC trusts own obligations.28

This

analysis turns on the ownership of the mortgage notes.

23

See, e.g., Burnet v. Harmel, 287 U.S. 103, 110 (1932). The tax definition of ownership would apply to the

mortgage notes. See Bradley T. Borden & David J. Reiss, Beneficial Ownership and the REMIC Classification

Rules, 28 TAX MGMT. REAL EST. J. 274 (Nov. 7, 2012). 24

See Bailey v. Comm’r, 912 F2d 44, 47 (2d Cir. 1990). 25

Grodt & McKay Realty, Inc. v. Comm’r, 77 T.C. 1221, 1237 (1981). 26

See Helvering v. Lazarus & Co. 308 U.S. 252, 255 (1939). 27

See id. 28

The lack of study should result in a finding that the mortgage note is not secured by an interest in real property.

11 8/31/2012

Kemp addressed the issue of enforceability of a note under the Uniform Commercial

Code (UCC) for bankruptcy purposes.29

The court in that case held that a note was unenforceable

against the maker of the note and the maker’s property under New Jersey law on two grounds.30

The court held that because the owner of the note, the Bank of New York, did not have

possession and because the note lacked proper endorsement upon sale, the note was

unenforceable.31

Recognizing that the mortgage note came within the UCC definition of

negotiable instrument,32

the court then considered who is entitled to enforce a negotiable

instrument but held that no such person was a party in Kemp.33

This analysis illustrates how courts may reach results that undercut arguments that

REMICs were the owners of the mortgage notes and mortgages for tax purposes. But even if the

majority of states rule in favor of REMICs, the few that do not can destroy the REMIC

classification of many mortgage-back securities that were structured to be—and promoted to

investors as—REMICs. This is because rating agencies require that REMICs be geographically

diversified in order to spread the risk of defaults caused by local economic conditions, REMICs

hold notes and mortgages from multiple jurisdictions. Most, if not all, REMICs own mortgages

notes and mortgages from states governed by laws that the courts determine do not support

REMIC eligibility for the mortgages from those jurisdictions. This diversification requirement

makes it very likely that REMICs will have more than a de minimis amount of mortgages notes

that do not come within the definition of qualified mortgage under the REMIC regulations.

29

See In re Kemp, 440 B.R. 624 (Bkrtcy.D.N.J. 2010). A claim in bankruptcy is disallowed after an objection “to

the extent that . . . such claim is unenforceable against the debtor and property of the debtor, under any agreement or

applicable law for a reason other than because such claim is contingent or unmatured.” See id. at 629 (citing 11

U.S.C. § 502(b)(1). This article cites to the UCC generally instead of specifically to the New Jersey UCC to

illustrate the general applicability of the holding. 30

See id. at 629–30. 31

See id. 32

See id. at 630. 33

See id.

12 8/31/2012

Professionals who helped structure these securitizations may face liability if the IRS were to find

that a purported REMIC was just purported and not a REMIC.